Understanding Risk-Adjusted ReturnsPosted on — Leave a comment
If two separate investments deliver the exact same return over the same period which is better? The concept of risk-adjusted returns helps answer this question.
An investment’s risk-adjusted return reflects the amount of risk an asset presents to deliver a particular return, or possible return. In other words, the risk-adjusted return reflects not only the assets earning power but also the potential for loss.
Here is another way to think about risk-adjusted returns. Consider two hiking trails that both lead to the same destination. One trail is treacherous. It has steep cliffs, jagged rocks, and rushing water. The other trail is flat, and straight. The second path, which presents less risk, is the one with the higher risk-adjusted return because the traveler incurs less risk in their journey to the destination. The first path has a lower risk-adjusted return because the traveler faces more threats on their way to the destination. They may get there but doing so might mean spraining an ankle or breaking a bone.
This measurement is helpful in comparing two investments that may seem identical when examined based only on their historical return.
There are several ways to measure risk adjusted returns. One popular method is to use the Sharpe Ratio which takes the return of the investment less the risk-free rate and divides it by the investment’s standard deviation. The standard deviation could be thought of as more rocks and cliffs on the trail. Typically, a higher Sharpe ratio represents a better investment choice.
The Sharpe ratio illustrates why an investment that delivers 14% in returns might be less desirable than an investment that only delivers a return of 11%. Why? Because the investment that returns 14% can only do so by exposing the investor to greater risk than the risk associated with the investment offering an 11% return.
This concept illustrates how investors can reduce the overall risk profile of their portfolio by including assets with higher risk-adjusted returns. For example, one study showed that allocating 5% to gold can improve the risk-adjusted return in a portfolio consisting of 60% stocks, and 40% bonds.
Now is a good time for investors to revisit the risk-adjusted returns of their portfolio because volatility in the stock market is climbing. Moreover, the median P/E ratio of the S&P 500 over a period of about 150 years is 14.9 and the current P/E ratio is 28.6. This significantly higher figure suggests that investors today have considerably higher expectations for future stock market performance.
Investors can counterbalance this elevated risk by allocating a portion of their portfolio to gold. The reason for this strategy goes beyond today’s heightened P/E ratio. Gold will likely also serve as a volatility stabilizer as the world continues to struggle with a fractured international response to a changing COVID pandemic. Additionally, the Federal Reserve’s recent plans to step back from quantitative easing may also spark a flight from stocks into relatively safer investments.
Risk-adjusted returns reminds us that not all profits are the same even if the percentages are identical. The path journeyed to reach those returns often determines the traveler’s fate.
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